City Journal

Steven Malanga

State Budget Bunk

A taxonomy of fiscal gimmicks, evasions, and ploys

Winter 2011

In a 2009 segment on Comedy Centrals The Daily Show, host Jon Stewart told viewers that many recession-hammered states had turned to unusual methods to raise money. Are any of these ideas actually stupid? Stewart wondered. Cut to Daily Show correspondent Jason Jones, who described Arizonas plans to sell its state government buildings for $735 million, lease them back, and keep on using them. Quickly discerning the problem with such a maneuver, Jones confronted Arizona state senator Linda Lopez: So youve got $735 million for this year. What happens next year, when you dont have that and youve got to pay rent? Lopezs awkward response: Thats always the problem, but we gotta get through this year.

Arizona is hardly alone in straining budget credibility to the breaking point. Facing scary revenue drops that left their budgets dangerously unbalanced after years of runaway spending, states have employed an unprecedented number of fiscal gimmicks over the last two years to try to make up the difference. They have swiped revenues dedicated to maintaining roads or enhancing emergency medical systems; sold future lottery proceeds for cash today; grabbed unclaimed money in personal bank accounts; and redefined taxes as fees to get around constitutional limits on tax hikes. And theyve justified these moves by claiming that voters are in no mood for the spending cuts or explicit tax hikes necessary to shrink deficits legitimatelyeven though the tricks often circumvent budget restrictions that the voters themselves enacted.

These deceptions may be fodder for TV comedians, but they are likely to have very serious consequences. Indeed, some of the fiscal problems now plaguing states result from budget ploys that legislators and governors created during earlier downturns and then failed to reverse when times got better. The ploys now support programs so generous that theyve become unsustainable except through fiscal shenanigans. These never-ending budget tricks undermine democracy, mortgage the future for junkie-like quick fixes in the present, and are a bigger part of states current fiscal nightmare than most taxpayers know.

Budget gimmicks have become more prevalent in recent years, but theyre nothing new; rather, theyre one side of an ongoing tug-of-war between politicians trying to keep the spending spigot open and voters trying to impose fiscal discipline on them. The tug-of-war dates from the 1920s, when New York State embraced constitutional reforms that, among other things, prohibited it from borrowing money, except to build long-term projects. The restriction paid dividends: within just a few years, investors deemed New York so creditworthy that the interest rate on its bonds was only slightly higher than that on the U.S. governments obligations. Other states soon followed with their own budget restrictions.

Sure enough, politicians quickly began trying to find ways around the limits without actually repealing them. In the mid-1930s, for instance, Pennsylvania lawmakers exempted government-owned corporations from state borrowing restrictions. The result was the creation of dozens of government bodies that started issuing bonds to do things once financed out of the states general budget.

Another key moment was New York governor Nelson Rockefellers introduction in the early sixties of moral-obligation borrowing. To circumvent requirements that voters approve borrowing, which until that point had always been repaid by taxes, Rockefeller started issuing bonds technically backed not by taxes but by a state promise. Rockefeller relied on the dubious concept to give state authorities a green light to raise billions of dollars for a host of pharaonic building schemes; state debt tripled in a decade, a state agency collapsed, and investors soon rejected moral-obligation debt.

The tug-of-war intensified in the 1970s, an era of tax revolts that saw activists successfully promoting spending caps to curtail fiscal irresponsibilityor so they hoped. Though Californias Proposition 13, passed by voters in 1978 to constrain property-tax increases, is the most famous of these laws, the Golden State actually came late to the party: bills in Indiana, Montana, Minnesota, Wisconsin, and elsewhere preceded Prop. 13 by several years.

But as with earlier reforms, politicians found inventive ways to skirt them. A 1982 study published by James Bennett and Thomas DiLorenzo in Public Choice found that budget restrictions enacted in 32 states in the 1970s did little to reduce public spending because state and local pols simply moved billions of dollars off-budget into quasi-governmental entities, largely controlled by political appointees. The principal reason for the establishment of OBEs [off-budget enterprises] in the U.S. has been to bypass the wishes of the electorate whenever the voters express a demand for fiscal restraint, the authors noted in their groundbreaking paper. Today, only about half of all state government revenues makes it into states main accounts and is subject to budget mandates. The rest flows into the off-budget enterprises, where voter-imposed fiscal restrictions dont apply.

And over the last couple of years, states have grown more dependent than ever on budget tomfoolery as they have faced record deficits. From 2004 through 2008, the states jacked up spending by nearly 35 percent, or about double the rate of inflation plus population growth. Then came the post-2008 economic downturn, and tax revenues plunged. Since late 2008, therefore, states have faced accumulated budget deficits of some $300 billion. Federal stimulus money helped cover about two-thirds of that yawning gap, but legislators have had to close the rest themselves. Many have resorted to methods that New York States comptroller calls a fiscal shell game.

One of the most common maneuvers is to fill budget holes with borrowed money. Arizona is a prime case. Since the housing bubble burst in 2007 and its economy began to contract, Arizona has borrowed approximately $2 billion, relying on new debt to close 17 percent of its budget deficits, reports the Arizona Capitol Times. Among the loans: $450 million that the state plans to pay back with future revenues from its lottery. The cost to the state over the next two decades will be about $680 million in principal and interestand to make its payments, Arizona has already extended the life of the lottery, which must be renewed every few years, and added more games. This may turn out to be an economic deal with the devil. According to 2002 research by economist Melissa Schettini Kearney, an associate at the National Bureau of Economic Research, state lotteries suck money out of the private economy, reducing household spending by nearly as much as the lotteries take in. If the projected revenue increases dont materialize, Arizona will have to pay off its debt with lottery proceeds that now fund transportation and social services.

When Arizona claimed to be selling its government buildings, it was engaging in a far more deceptive kind of borrowinga gimmick known as tax-exempt certificates of participation and even more preposterous than the Daily Show correspondent realized. There was no new owner in this so-called sale. Rather, the state floated more than $1 billion of notes, promising to repay bondholders with the rent that it would pay to lease the buildings. Since rent, not tax revenues, technically would repay the certificates, Arizona could borrow the money, even though it exceeded the states constitutional debt limit. Yet Arizona will pay the rent on the buildings with tax revenues, so the impact on taxpayers is exactly the same as more borrowing would have been: in this case, $1.5 billion in future taxes. The Arizona legislature has done everything it can to pretend that life hasnt changed since the housing market collapsed, and borrowing to close its budget gaps is one good example of that, says Byron Schlomach, a fiscal analyst with the Goldwater Institute in Phoenix.

States are employing an array of other techniques that amount to borrowing without issuing debt. One strategy is simply to stop paying the bills. In Illinois, unpaid bills have reached a jaw-dropping $4.4 billion, according to the states comptroller. California, meanwhile, famously issued nearly 450,000 IOUs, totaling $2.6 billion, in 2009. Creditors kept waiting for months included staffing firms that supplied the state with temp workers and businesses that provided technology services. Even neighboring Nevada got stuck with an IOU (for $33,383) after sending firefighters to battle California wildfires. Nationwide, states unpaid bills have soared by nearly $100 billion, or 18 percent, since the end of 2007.

California also extracted what was essentially an interest-free loan from its taxpayers. It increased withholding rates for the state income tax for the last two months of 2009, collected about $1.7 billion, and held on to the funds (without, of course, paying any interest to the taxpayers to whom they belonged) until the next springs tax refunds. But that move worsened Californias budget problems in fiscal year 2010 because the state paid the 2009 refunds with 2010 tax revenues, leaving less to pay current bills.

Some state constitutions permit undisguised borrowing to patch budget gaps, provided the debt is quickly paid back. The problem is that it often isnt. Connecticut, for example, will close its current budget deficit with $646 million in borrowing through economic recovery bonds, which will cost the budget an additional $131 million in interest payments. The state also borrowed money during the 2003 downturn and in the early 1990s. All this borrowing has added up: today, Connecticuts debt per capita is the nations second-highest, and the fourth-highest as a percentage of household income.

More and more, states pay their bills with borrowed money even in good times. Take Illinois, which doesnt collect enough in taxes to finance public employees retirements. In 2003, Illinois floated $10 billion in bonds to pay for the pensions. But then the state failed to contribute adequately to its pension funds in the subsequent boom years. Soon, it had to borrow again for the same reason: $3.5 billion in 2009 (and that adds up to $4.5 billion in future principal and interest payments). Last year, it took out yet another $4 billion loan. Meantime, Illinois is still paying off the original 2003 bond offering by diverting tax revenue from other uses. In Illinois, politicians dont even pretend that their deficit borrowing is to preserve essential programs, like for the needy, says Jim Tobin, head of the National Taxpayers Union of Illinois. The money is to keep paying union benefits that the state cant afford.

But untrammeled state borrowing becomes most apparent during economic downturns and the big deficits that accompany them. From 2008 through the second quarter of 2010, state and local financial liabilities, including debt outstanding and unpaid bills, swelled by some $290 billion.

Not all of the state budget trickery involves borrowing; some of it simply betrays pledges to taxpayers. One common example is sweeps, a term that refers to shifting money from adequately funded accounts into depleted ones. In some cases, the revenues that get swept come from taxes and fees that politicians had promised would pay for specific tasksmaintaining roads, say, or improving emergency services, or even paying for unemployment insurance. With the transfers, however, the money gets used for something entirely different.

One tempting area for sweeps is taxes designated for upgrading 911 emergency responses. An August survey by the Federal Communications Commission reported that states redirected $135 million in these taxes last year to spending for other purposes. New York is a serial abuser: shortly after enacting a cell-phone tax to fund an emergency-services upgrade in 1991, a Buffalo News investigation found, the state began diverting the revenues, and it has been diverting them ever since. So far, New York has collected an estimated $600 million from the tax and sent just $84 million to local officials for upgrading emergency services. Today, out of every $1.20 in 911 taxes, New York uses $1 for other purposes. Many of the states counties have been forced to levy their own 911 taxes to pay for actual upgrades.

Other states have followed New Yorks lead. Wisconsin finished upgrades on its 911 system, diverted $25 million of surplus funds from an emergency-services tax that was supposed to phase out when the necessary work was finished, and extended the tax. In Oregon, the states attorney general determined that a sweep of 911 funds ran afoul of federal law; undeterred, Oregons legislature swiped the money anyway.

Fees from expanding industries are a popular sweeps target. In Colorado, for instance, the medical-marijuana business has been growing rapidly since voters legalized it in 2000. The $90 registration fee for users is supposed to finance legal enforcement of the industry. But in 2010, then-governor Bill Ritter siphoned $9 million out of the fund to help close the states budget gap, leaving just $1 million behind.

Fund transfers have grown so common that some states must now do reverse sweepsthat is, send money from their general funds back into accounts so depleted by previous sweeps that they can no longer meet their obligations. In 1991, New York created a fund to finance bridge and road construction and maintenance but quickly began transferring money out of it and borrowing to replace what had been transferred. About a third of the funds resources now go toward debt service, a figure projected to rise to 70 percent by 2014. So New York is shifting tax dollars from its hard-pressed general fund to help pay off the transportation accounts debt. No wonder a state comptrollers report labeled such maneuvers fiscal manipulations intended to give taxpayers a distorted view of the States finances.

As states have tried to get their hands on more and more dedicated funds, theyve provoked intensifying opposition, including expensive legal challengesespecially in cases where states take money from accounts that arent taxpayer-funded. New Hampshire, for instance, lost a lawsuit when it tried to seize $110 million in surpluses from a state-operated medical-malpractice insurance fund financed by doctors. In Arizonawhere sweeps provoked 18 lawsuits in 2008 and 2009 alonea judge ruled that the state broke the law when it took $160,000 from accounts intended to pay for agricultural research and financed by private donations.

Now states are even eyeing citizens private bank accounts. If the post office repeatedly isnt able to deliver your bank statement or if your account is otherwise idle, states have long been able to grab the funds in it. But theyre starting to shorten the amount of time that must pass before they do. Last year, Michigan shrank the required period from as long as 15 years to just three; the state believes that the move will yield a one-time bonanza of more than $200 million. New York, New Jersey, and other states have likewise shortened the time that money can remain unclaimed.

States have also evaded constitutional and legal limitations on tax hikes by magically redefining some taxes as fees. In Washington State, raising taxes requires a two-thirds majority in the legislature, but raising fees requires only a simple majority. So the legislature, lacking the necessary votes to increase the tax on tickets to boxing and martial-arts events, simply renamed it a fee. These forms of revenue boosting are covert and less likely to be noticed or to incite voter outrage, note Amber Gunn and Brett Davis, two analysts with Washingtons Evergreen Freedom Foundation.

In California, howeverwhich gets about 17 percent of its revenues from feesvoters did notice. In November, they approved Proposition 26, a ballot measure that supporters dubbed the Stop Hidden Taxes initiative, which requires that in the future, many kinds of items that the state has called fees will be called taxes and thus be subject to the states constitutional requirement of a two-thirds legislative vote for approval.

During the current recession, voters have expressed outrage at public employees rising numbers, plush salaries, and lavish benefits. States have accordingly enacted reforms to counter the power of government workersbut even these have been twisted into budget gimmicks by politicians. Illinois, to take one example, passed modest pension reforms last year that apply only to new workers, meaning that the savings from the measure wont show up for years. But the legislation also included language that let the state apply up to $300 million of those future savings toward closing this years budget gap. The deal leaves Illinois right where it waswith a pension system only about 40 percent funded and in danger of running out of money within the next decade.

Early-retirement plans have become another vehicle for fiscal trickery. At first, the plans may seem an attractive way to downsize the government workforce. Michigan, for instance, recently passed a retirement plan to provide generous additional benefits for up to 6,400 retirees, who can step down at 59. The plan supposedly will save the states general fund about $80 million in its first year.

Or will it? Consider some recent experiences with early retirement. Back in 2003, Connecticut embraced an early-retirement plan to reduce the state workforce by several thousand, booking the savings straightaway. But then the state rehired some 1,000 of its early retirees as temporary workers who collected salaries in addition to their pensions. By 2008, some of those temporary employees were still working for the state and collecting pensions, a Hartford Courant investigation discovered.

Or look at Illinois, which launched a massive early-retirement plan during the last recession, in 2002. The state originally estimated that it would cost only about $80,000 extra per retiree, but after legislators added all the union-demanded sweeteners, that price tag ballooned to $200,000. Approximately 10,000 employees rushed to take advantage of the plan, further shaking an already tottering pension system. The systems payouts to retirees rocketed in one year from $640 million to an estimated $1.6 billion. The same thing happened in New Jersey, according to a study performed by the legislature: some 4,000 workers took a 2002 early-retirement plan, which saved the state $314 million in compensation costs, but at a long-term cost of $645.4 million to the pension system. The drain of early retirements is one reason the states pension funds are running out of money.

Politicians have figured out that these schemes arent fiscal winners but merely another version of savings today at a steep price tomorrow. Thats probably why they rarely bother to estimate the true cost of early retirements. A study by the Manhattan Institutes Empire Center found that New York State used ten different early-retirement programs between 1983 and 2002, but noted that the state had never done a cost-benefit analysis of any of them. Last year, New York offered another early-retirement plan: it ostensibly trimmed payrolls by 3,600 workers, but within a few months, a New York Post investigation found, hundreds of those workers were already on the payroll again in temp jobs while collecting retirement wages. The savings from early retirement are seldom real savings in the long run, observed Gerard Miller, a strategist with PFM Group, a public finance consulting firm, in Governing. Ultimately, taxpayers will pay a higher bill for those early pension benefits and retiree medical benefits.

Budget gimmicks may be one-shot revenue enhancers, but their harmful effects reverberate down the years, undermining states long-term fiscal stability. Nothing illustrates this more clearly than Californias recent history. Back in 2004, Governor Arnold Schwarzenegger promised that the state could fix its woeful finances if voters would just approve deficit borrowing in the form of economic recovery bonds. The voters, who had just removed Governor Gray Davis over his mismanagement of the budget, approved the bonds; the state borrowed $10.9 billion, increasing Californias general debt by 31 percent. Relieved by the loans of its immediate financial squeeze, Sacramento then discarded (again) fiscal discipline, hiking spending by nearly a third, or $34 billion, over the next four years. The state found itself in another deep hole by 2008.

But California is only the most obvious example. New Jerseys current inability to pay for infrastructure improvements out of its depleted transportation fund is the result of sweeps that drained the fund to close budget gaps. Illinois dire pension shortfalls didnt occur overnight, but worsened over years of budget tricks that the state never made right. It has been 20 years since New York, to close a budget deficit, bought Attica Prison from itself with money raised from a bond issue; today, the state is still using current tax dollars to pay off the interest.

Reformers should use the current downturn as a starting point to demand new measures that end many of these abuses. Though reforms will differ from state to state, several sensible principles should govern change. One is for states to switch from yearly budgets to balanced multiyear plans, so that legislators wont be able to employ tricks one year and ignore their consequences the next. Another is for states to tighten restrictions on borrowing to include debt issued by quasi-governmental entities and authorities. States can also increase the amount of money that their reserve accounts must hold during good economic times, which would both restrain the growth of government during the good times and provide a cushion against severe revenue falloffs in recessions. Such reforms would represent the next stage in taxpayers never-ending battle against budget gimmicks.

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